Monday, August 6, 2012

Weidmann, the last major independent voice among Eurozone's central bankers

As Draghi is pulled over to the "dark side", effectively becoming a tool of the area's political leadership and making the ECB increasingly less independent, Bundesbank's Weidmann is fighting an uphill battle to stay independent. That is generating a rift between Weidmann and the ECB. Bundesbank is even in conflict with its own government, which is going along with the ECB's plan of more bond purchases (as discussed here).

NASDAQ/Dow Jones Newswires: - Germany's central bank Monday reaffirmed its opposition to the European Central Bank purchasing government bonds on the secondary market, dashing hopes that it might hold back criticism on the program. The comments also appear to put the bank in conflict with the German government.

The comment comes days after ECB President Mario Draghi said it was prepared to re-start its program of buying euro- zone government bonds on the secondary market if troubled states applied for assistance from the euro zone's bailout funds.

Bundesbank's stance is making the central bank increasingly isolated in the Eurozone, as the area's leadership pressures the ECB to contain the crisis.

Reuters: - "How much longer?" German business daily Handelsblatt asked in its front page headline on Friday, questioning how long Weidmann could stand being isolated on the [ECB's] Governing Council.

Weidmann has been in the minority for much of the time since succeeding Weber in May last year, though Draghi has sought to play down any hint of a split within the Council until now.

Speaking after the ECB's March policy meeting, the Italian Draghi said: "Nobody is isolated in the Governing Council. And the Bundesbank especially is not isolated."

In spite of his statement, apparently Draghi (supported by his political allies) has in fact attempted to isolate Weidmann.

Reuters: -
"It's clear and it's known that Mr Weidmann and the Bundesbank - although we are here in a personal capacity and we should never forget that - have their reservations about programmes that envisage buying bonds," Draghi said.

"The voting was, as I said, unanimous with one reservation," he later added.

But two central bank sources said there was no formal vote at Thursday's meeting and one of them said Draghi is trying to isolate Weidmann.

The math that makes Weidmann uneasy and resentful of this program is simple. The ECB holds €220bn of periphery bonds directly, €1,117bn of loans to the banking system (mostly in the periphery), and €205bn of emergency loans via the national central banks. And now the ECB may embark on further bond buying, potentially in the hundreds of billions worth of the same credits.

Borrowing from the ECB (€ bn) by the banking system (source: BNP Paribas)

Of course some argue that the loans to the banking system are collateralized, posing lower risks to the ECB. But the collateral for these loans represents credits of the same countries.
Just to put things in perspective, back in 1998 firms such as First Boston, who had tremendous exposure to Russia, hedged themselves with ruble FX forwards. This strategy would have worked, except the forwards were executed with Russian banks. And when the government defaulted, the banks reneged on the contracts (in part at the request of the government). The point is that in a sovereign default, the "joint probability of default" between the government and the nation's financial institutions is close to one. This is particularly true in much of the Eurozone, where the lines between the government and the banking system are blurry. We saw that with Greece for example.

Weidmann must be asking how much more will be needed. How much periphery exposure is to be transferred from private hands to the ECB? And more importantly, should it even be a central bank's responsibility to rescue its government? Weidmann continues to argue that it should not. As an independent central banker he clearly wants no part of this. But as Handelsblatt asked, "how much longer" before Weidmann, as a member of the ECB's Governing Council, succumbs to the pressure?